This article covers some investing tips based on adjustments I’ve made to my defensive value investment strategy in response to the coronavirus pandemic.
So far this pandemic-driven downturn is nothing like a normal recession.
With high-quality companies suspending their dividends left, right and centre, the economic consequences of coronavirus are much more sector specific and much more devastating than we would normally see.
As a result, I’m sure that many investors have had to re-think their approach to buying and selling stocks as they attempt to minimise risks and maximise returns from their portfolios.
I’m no different. Over the last couple of months, I’ve made a few minor adjustments to my “defensive value” investment process which, I hope, will steer my portfolio through the storm and leave it well positioned on the other side.
These adjustments are based on sensible principles and I think they’ll apply to a wide range of investors.
Tip 1: Don’t sell at depressed prices
Until recently, my approach to buying and selling shares went something like this:
- January: Use my stock screen and investment checklist to look for a “special” company which is likely to be highly profitable and produce relatively consistent growth for at least the next ten years. If I find one where the share price and dividend yield are attractive, invest about 1/30th of the portfolio into that company.
- February: Look at the portfolio’s holdings (typically about 30 companies) and find the one with the least attractive combination of “specialness”, valuation and dividend yield. Sell that holding.
- March: Repeat the buying process from January, reinvesting the proceeds from last month’s sale.
- April: Repeat the selling process from February.
- Alternate between buying and selling each month until the end of time
I’ve followed this monthly buy/sell process since 2011, with virtually no deviation from its soothingly monotonous rhythm.
But now all that has changed, and thanks to the coronavirus pandemic I haven’t sold anything for months.
The last holding I sold was Aggreko, way back in January. You’ll have to read the article for the full details, but basically I sold it because its fortunes are heavily reliant on the highly cyclical oil and gas industry, which I’m no longer comfortable investing in.
In February, just before the market collapsed, I added another company to the portfolio as per my usual buy/sell schedule.
March should have been another sell month, but after looking through my portfolio I decided not to sell anything.
There are a couple of reasons why, both of which are tied in with my preference for selling holdings which are either a) high on valuation multiples or b) low on specialness.
Let’s start with highly rated stocks. Like many investors, my portfolio is basically devoid of stocks trading on high valuation multiples. This is not exactly a surprise as we’re in the middle (or more likely towards the end of the beginning) of a global pandemic and are potentially facing the most severe UK and global recessions we’ll ever see.
So from a valuation point of view, there’s nothing I want to sell.
As for holdings which lack specialness, I do have a few candidates.
Long-time readers will know I’ve had problems with Ted Baker and a disaster with Xaar in the last year, and both of those companies lack the special qualities I’m looking for. I thought they were special when I bought them, but they weren’t. The relevant lessons have already been learned and integrated into my investment spreadsheet and checklist.
Both of those companies are at the top of my sell list, so why haven’t I just manned up and sold them?
There are a couple of reasons (which I hope are more than just excuses to avoid locking in unpleasant capital losses).
First, their share prices are both down about 90% from where I bought them, and together they now make up barely 1% of my portfolio. With such a tiny allocation to each company, I don’t think it will make much difference whether I sell them now or in a few years’ time.
Second, given their disastrous results, I want to learn as much from the experience as possible. So rather than selling up and running away, I’d rather hold onto them because they could throw up some important lessons as management struggle to turn each business around. I won’t learn those lessons unless I have skin in the game, and that’s the main reason I’m holding on.
This “hold onto your disasters” strategy is somewhat like the story of Warren Buffett and Berkshire Hathaway (yes, I’m comparing myself to Warren Buffett), where Buffett kept the original Berkshire name for his expanding conglomerate as a reminder that buying Berkshire was perhaps the biggest investment mistake of Buffett’s life.
In summary then, I’m not selling anything at the moment either because a) most of my holdings are trading at depressed prices or b) I want to learn from disasters by watching their turnarounds succeed or fail.
So what am I doing if I’m not selling anything? I’m glad you asked.
Tip 2: Diversify more
For the last three months I’ve bought a new holding every month and this may continue for some time.
The main reason for this buying spree (if you can call one purchase per month a buying spree) is that I want to make the portfolio more diverse.
It was already quite diverse, with around 30 holdings operating in a wide range of industries and geographies, and with no single investment making up more than 6% of the total. But these are extraordinary times, and even the best companies in the wrong sectors (e.g. travel and retail) are suspending dividends and announcing rights issues.
So to err on the side of caution I’ve decided to add a few more holdings, partly to add some (hopefully) lower risk companies to the portfolio, but mostly to reduce the impact of any one company going bust (a not inconceivable event in the current environment).
Buffett says “diversification is a protection against ignorance” and I accept that entirely. I don’t have a crystal ball and I don’t have Buffett’s photographic memory or stratospheric IQ, so protecting the portfolio from my ignorance of how this pandemic will pan out seems like a good idea.
By default my portfolio has 30 holdings and after the latest purchase it’s up to 33. By investment fund standards that’s still concentrated, so I’m confident that I’m not over diversified just yet.
I could just keep adding one more holding each month forever, but that seems a tad excessive. More realistically, I think something like 40 holdings is as high as I would want to go.
If I keep buying one company every month then I’ll hit that upper limit near the end of 2020, so if the pandemic is still a major problem at Christmas then I may have to eject Ted Baker and Xaar to make room for some higher quality companies.
Okay, I’m buying rather than selling. But what am I buying?
Tip 3) Buy defensive companies
The basic gist of my defensive value investment strategy hasn’t changed.
I’m still trying to buy “special” companies at attractive valuations and with decent dividend yields, but as an added layer of protection in these highly uncertain and unprecedented times, I’m specifically focusing on buying defensive companies.
Traditionally defensive companies sell things that people need come hell or high water. Think toilet paper, cigarettes, car insurance, soap, food, electricity, internet access (more essential than food for some people) and so on.
When you’re facing a global pandemic where “non-essential” retail stores are forced to close and people are told not to travel, one thing you can be sure of is that people will still need to eat, drink and use the internet.
Unfortunately the idea of investing in defensive companies during a pandemic is pretty obvious, so most of the high quality (or at least fair quality) defensive companies that spring to mind (e.g. Diageo, AG Barr, Greggs, Reckitt Benckiser, Unilever) are a long way from being obviously cheap (which is not the same as saying they’re obviously expensive).
That’s a shame, but it’s the reality of investing in a very efficient market where obvious strengths and weaknesses are priced into stocks almost instantaneously.
Even so, I have added one traditionally defensive company to the portfolio in recent months and I’m actively looking to invest in others, as long as the price is right.
If you’re having trouble finding traditionally defensive stocks at attractive prices, one alternative is to invest in cyclical companies which are exposed to a significant part of the global economy.
Tip 4) Buy cyclical companies with industrial and geographic diversity
Take a look at these three example companies:
- A clothing retailer with one store in Basildon
- A clothing retailer with 500 stores around the world
- The global leader in highly regulated protective clothing which is mandatory for workers operating in a wide range of industries
The first company is geographically and industrially concentrated. Anything negatively impacting the economy in Basildon will likely have an impact on the company.
The second company is geographically diverse, but industrially concentrated as it only sells regular clothing. This company might be largely immune to a downturn in the UK, but a global downturn could still see many customers saving their pennies rather than spending them on fashion items.
The third company is both geographically and industrially diverse. It sells items which must be worn under certain conditions, and it sells them to customers operating in a wide range of geographies and industries.
For external events to have a serious impact on the the third business they’d have to severely impact many industries across a large part of the globe.
The current pandemic will obviously have exactly that sort of impact, but unlike the fashion retailers, the protective clothing manufacturer’s revenues won’t go anywhere near zero as long as we have a functioning global economy which needs people wearing protective kit to keep the wheels of industry turning.
A company selling highly regulated protective clothing to many industries in many countries is just one example. There are all sorts of businesses with industrially diverse global exposure and I think they should (hopefully) provide some degree of defensiveness against the worst effects of the pandemic, without being traditionally defensive businesses.
Having said that, do not be surprised if they suspend their dividends as a precautionary measure, and dividend suspensions alone are by no means a negative sign in the current crisis.
Of the four companies I’ve bought in recent months, three have fit this mold. They have traditionally cyclical business models, but they’re somewhat more defensive thanks to their industrially and geographically diverse products, services and customers.
Tip 5: Keep calm and carry on investing
My final tip is just a general point about not panicking and not running for the exit when markets get ugly.
Stock market history clearly shows that selling at the moment of peak fear is always a bad idea. In this latest crisis, selling at the bottom would have netted you a loss of about 36% for the FTSE All-Share.
If you managed to avoid selling then the few short weeks will have netted you a gain of about 20% from that low point, if your returns are anything like the FTSE All-Share’s.
My biggest gainer is up more than 200% since the market low, so clearly selling at that point would have been a very bad idea.
Tips for sensible investing
So there we have it. A handful of tips which may be useful for steering a portfolio through a global pandemic, while positioning it for the inevitable recovery a year or three from now.
If you’ve made any adjustments to your own investment process in recent months, feel free to mention them in the comments below.
Hi John,
My investment process hasn’t really changed much but it pertains more towards Buffett concept of “Circle of Competence”.
I think the key to successful investing is to be able to correctly evaluate a selected group of business. The most important element is knowing that boundary because it protects you against making the fatal mistake ” of don’t know what you don’t know investing” this is where most investors lose their money.
For example if you had a through understanding of FMCG sector and decided to invest £5,000 in Unilever March 2009 you would have received 384 shares. This would now be worth £15,907 and you would have received approximately £4,074 worth dividends on top. On the other hand if you invested in the FTSE All Share Index it would only be worth £7,704 therefore diversification just gives you peace of mind rather than a good return.
Hi Reg, I’d be careful with Buffet’s circle of competence.
He hasn’t covered himself with glory these last years and his top 20 now looks pretty ugly with 4 airlines chopped at drastically reduced prices, 5 banks which have fallen more than 50% and he has offloaded US Bancorp even at the greater than 50% drop. Wells Fargo is down at $22 from $57 and was one of his biggest holdings.
Kraft Heinz has lost him a serious fortune.
Might be better to look toward Terry Smith who seems to have come out of this quite well, so far. I say so far, because I don’t know this is over as yet.
LR
Hi LR,
The problem with using Terry Smith as an example of what to do is that his fund is only 10 or so years old, and has operated in an environment tailor made for his defensive quality approach. As you say, that may or may not be true over the next 10 or 20 years, although I do think his approach is fundamentally very sound.
John, in terms of the fund I agree, but Smith deployed the system many years before he started the fund when managing company pension schemes. There is a presentation to the Istitute of Directors you can watch on his web site, which shows the actions and the long track record of the pension fund which was turned around from a distaerous poor performance to a positive return over many years using the similar quality investments. It is never perfect, but one of the key realisations that has dawned on me is the risk management is far more though through compared to many fund managers and our goodselves. It is pretty clear that Terry would avoid companies that look like short term value opportunities and pass up on them in the view that the ultimate return on capital is key and that the company has to command a pretty much winning formula in its market.
“the company has to command a pretty much winning formula in its market”
This is something I’ve learned the hard way over the last ten years (perhaps especially last year). My approach these days, somewhat thanks to Smith although I think mostly Buffett, is to look for companies that have already won in their market, rather than companies that are simply “above average”.
Valuation still matters hugely of course and even Smith, who derides value investing, has “don’t overpay” as one of his rules (which basically makes him a value investor). But I agree with you that competitive strength should come first.
Remember Smith also has the advantage of the flight to safety in the US dollar. This is an instant boost since most of his holdings are in the United States.
Hi Reg
Although I agree that investing in “special” businesses at reasonable prices can be a good way to invest (that’s basically what I try to do), I don’t see it as an excuse to avoid sufficient diversification.
We all know the story of Buffett putting 30% or so of Berkshire’s capital into Coca Cola in the 1980s, and that worked out incredibly well. But I think it’s a mistake for most investors to try to replicate that because a) they’re not Buffett and b) they’re not Buffett.
Unilever is a commonly used example of a quality company, but I think you could just as easily chosen Reckitt Benckiser, which is similar in many ways.
If you’d loaded up on RB in mid-2016 then you would have suffered a small capital loss to today, some four years later. Now four years isn’t long enough to make any serious statements about an investment’s performance, and I’m not saying RB isn’t a quality company, but it’s too easy to cherry pick past winners and use that as evidence that most active investors should concentrate on quality companies at the expense of diversity.
I think investors are better off staying diversified, because as the coronavirus has shown, the future is an uncertain place.
Having said all that, investing is an art as much as it is a science, so if an investor wants to hold a super-concentrated portfolio (perhaps 10 holdings) then that’s fine by me.
Hi John,
I think concentrated investment can work if you get the stock at the right price. Unilever was just one example but I have found when market has discounted other quality companies in the past a similar performance could be attained.
The only downside is that to make this work you do need to spend a lot of time learning about the business and sectors that interest you. This should help you filter the companies which would be a bad investment. At least thats what I do most of the time learning about businesses and their respective sector.
John, Interesting times and rather drastic times to say the least.
I think I’m unlikely to invest in several sectors in view of the current potential change in the the world economy and people’s habits and way of life.
I was never a fan of airlines, travel companies, transport or property companies, therefore I don’t see me bothering with any of those sectors going forward.
I guess that has now extended to pretty much all retailing, hospitality and entertainment – social distancing is potentially going to destroy many in these sectors anyway – including pubs/restaurants/event venues/hotels/high street retail/automotive
Fortunately I sold Ted Baker and took a loss a while back but unfortunately retained a small position is Marks and Spencer and like you it seems too late to sell as it has been decimated. By luck I decided to sell JMAT and Amadeus before the crash, and it hasn’t recovered, nor has much of the auto/aerospace sector.
That leaves a few possibly more viable sectors :-
Consumer staples and discretionary – but I see your value concerns
Payments
Software
Specialist heathcare
Telecom / TV / Streaming
Security
Financial (preferably excluding banks and insurance companies)
Gold – It’s been rising for 4 years and money printing probably means it will continue to do so.
Most if not all these sectors don’t rely on direct social interaction except of course alcohol consumption will change its venues somewhat and could be impacted.
Treading carefully seems to be the main motto!
LR
Hi LR
The areas I’ve seen holding up well (off the top of my head) from a corporate rather than share price point of view are:
Payments
DIY retail (eg wallpaper etc as everyone’s doing video calls and so need to decorate their house/garden)
Security and cleaning services
Widget manufacturers with broad industrial diversity
insurance
food retailers
stock trading firms
I’m sure there are others. As I said in the article, my focus now is on companies selling products/services that people must have no matter what, or companies selling products/services to customers in a huge range of countries and industries.
Treading carefully is definitely rule #1 at the moment.
Of course you don’t want to be like a first world war veteran and after this crisis is over build a Maginot line of investments. The next crisis maybe very different to this one.
Hi Lr,
I agree that the recent investments of Buffett hasn’t worked out very well compared to his past performance. However he still managed to consistently beat the market by a huge margin for 30 odd years meaning that his method is pretty good and something worth looking at especially the idea of circle of competence.
Very interesting point you make about the recent loss it seems a complete odd to what he did in the late 80s when he offloaded all stocks except GEICO, ABC and Washington Post. My only explanation is that Buffett is a very old man now it makes me wonder what is the state of his mind?
Reg,
It seems the “state of mind” of Warren Buffett remains formidable. He recently presented for 6 hours and demonstrated remarkable memory of financial history and valuable insight regarding the current turmoil.
I don’t follow him closely but I listened to several podcasts where his followers remain impressed. An interesting comment is that he claims he has not (yet) spent any of his gigantic cash hoard on ‘bargains’. He encouraged retail investors to continue purchasing equities each month but he seems to be waiting for a better opportunity.
Hi Ken,
Just to clarify when I was referring to state of mind I was thinking of Buffett’s emphasis on circle of competence.
By definition by sticking to a sector you know inside out it enables to act as a filter for what would be a good investment and what would be a bad investment. Kraft Heinz for example has been problematic for a long time for various reasons.
Unfortunately it seems that Buffett is unwilling to either acknowledge the issues Kraft Heinz has been experiencing or ignorant of them. I once read an excellent book called “Niche: The missing middle and why business needs to specialise to survive” this was published in 2012. It dedicates a section to Kraft and Maxwell Coffee explaining the poor fundamentals of these business.
Therefore it makes me one wonder what is going through his mind? As the problems Kraft is facing has been brewing for a long time. Nevertheless I have the utmost respect for his track record and his sound framework.
John, you opened 3 new positions but did you add to any existing positions?
Hi Ken, in the model portfolio I don’t ever add to existing positions for the sake of simplicity. In my personal portfolio (which holds exactly the same stocks) I was intending to add to some positions but decided to keep the funds as a cash buffer, given that the economic situation in the UK could impact the UK Value Investor business for a while.
Hello John,
I’m a german so my english is not the best …. this is one of the first comments on a website outside from Germany ….. I am also a Dividend investor and wish you all the best … great blog … I come back … I own seven stocks …
Thanks a lot for the inspiration
Yours sincerelly
Uwe
No problem; good luck with your website.
Hi John
Thanks for sharing what you are doing differently in the current situation.
Personally,, I’d always been uneasy with a strict sell/buy monthly cycle so I’d modified your approach to a quarterly review with the OPTION to sell/buy depending on the status of the market and my individual holdings. It works for me as it means I tend to have more cash at the top of the market and invest when stocks are good value at the bottom.
My approach at the moment is basically to sit on my hands. I like to think of it as a cycle race where the organisers will neutralise it in exceptional circumstances (like hail storms in last years Tour) and only restart racing when the situation is (close to) normal. As you have always said, the future is unknowable but at the moment I’d say it’s also unpredictable and so buying would feel too much like day trading to me. And I’m certainly not going to sell anything, for reasons you rightly point out.
It’s boring not being more active but I think my portfolio will thank me in 6-12 months time.
Hi Steve, very sensible. I think doing nothing is an entirely appropriate response.
I think in my case there are still a few legacy stocks in the portfolio which are heading for the exit some time soon, so this is an opportunity to buy up their replacements at what appear to be reasonable valuations. I think perhaps towards the end of this year I might have a few months of selling instead of buying, but it all depends on how this pandemic pans out.
I’m sure you’re aware that the marginal diversifying benefits of more holdings decays as the number of holdings increases.. why not add gold and/or bonds? Just a relatively small 10% holding an alternative asset class will likely have more diversifying benefits than going from 20 to 40 holdings.
Hi vand, adding bonds or gold is an entirely reasonable option. However, my model portfolio is a 100% equities portfolio so that isn’t an option in this case.
I agree that just adding ever more stocks isn’t a great idea, and this increase in holdings is temporary. As the situation normalises I’ll offload some unwanted stocks and be back to about 30 holdings, probably sometime in the next year.
I love your recommendations, thanks for sharing them!
I agree with buying the cyclicals but at the same time I keep using the opportunity to increase my position on some European consumer staples and pharmas (i.e. Unilever, Novartis, Danone). They still provide quite some value and interesting yields.
Thanks. I agree that a balanced approach makes sense, but I do balk at the valuations of some defensive stocks.
Thanks John for the thinking in these difficult times.
US CAPE remains troubling so entered the year with circa 50% Cash.
Bought into the dip through gritted teeth, but Cash% remains high.
The V recovery has surprised. Investors buying because the market is going up and fearing they may be missing out ? Have an uneasy feeling these unreliable investors may flee on any sign of weakness – so further downside cannot be ruled out ?
With dividends and earnings evaporating in some otherwise fine companies, turning in perhaps desperation more towards P/B, as the last measure standing (for now).
Do not want to exclude those fine companies purely because dividends cancelled or deferred. One day those dividends will return.
Hi Bob, I agree with your last point. Normally dividend suspensions are a very bad sign, but in this environment they have become the norm, with even very defensive companies suspending dividend payments just to be on the safe side.
I think many dividends will be rebased as we come out of this, but dividends from the best companies will eventually exceed their old highs.
Hi, thank you all for sharing. I sold 90% of my stock after a 10% drop in the market. From years past, I checked market falls and 5% to 7% had many quick recoveries, however, 10% falls normally meant something very serious was afoot and usually meant the market was about to fall to an unknown level.
Over the past three months, I´ve reinvested each week and now I´m 40% reinvested. Today I intend to use another 7% for purchases which will be partly based on advice given within your comments. I should add that if the market were to fall again by 10% within these troubled and perplexing times, I would sell all recently bought stock.
I don´t normally write to blogs, but as you all seem to have held your stock, I thought an alternative opinion may be of interest.